Economic Logic, Too

About Me

I discuss recent research in Economics and various events from an economic perspective, as the name of the blog indicates. I plan on adding posts approximately every workday, with some exceptions, for example when I travel.

Saturday, October 30, 2010

Last week, I suggested that democracy is not as good as many people think. I want to add on this that democracy should not be the first item on a list of priorities. In a broader sense. when the United Nations adopted the Universal Declaration of Human Rights, it put way too much emphasis on political and civic rights, and too little of economic rights. According to this document, having the right to vote is more important to have enough to eat.

But putting absolute priority on political rights, this Declaration and the ensuing foreign policies of most western nations have wasted precious resources in trying to impose democracy to countries that were rather longing for a better living standard. In particular, I find it obscene that western nations tell developing countries to democratize while at the same time denying poor farmers proper access to export markets by subsidizing domestic agriculture.

One has to recognize that there are trade-offs. Democracy and political rights should be enjoyed, no question about it. But the priority, at least to me, should be on a decent economic life. And even if it is not a priority to others, they should recognize that democracy and political rights should not be imposed at all costs.

Friday, October 29, 2010

The papers about sovereign debt I come across always assume that the debt is held by some social planner who implicitly is acting on the behalf of representative and identical agents. But not all international debt is held by governments, and not everyone in a country has the same opinions regarding this debt.

Martín Gonzalez-Eiras deviates from this literature by including demographics, and in particular how there can be intergenerational conflict about the handling of debt. Obviously, reneging has different consequences whether you are young or old. He also looks at how outcomes can differ if the demographic structure of a country changes.

The paper highlights one interesting mechanism that should provide larger incentives to prevent default. Important transfers between generations are welfare improving, and they can further improved by having access to international insurance. This implies that these intergenerational transfers act as international collateral, and thus make it possible to obtain self-enforcing contracts. A country with a large retirement pension system provided by the state is this less likely to default and more likely to obtain gains in efficiency through participation in international insurance.

Thursday, October 28, 2010

You have heard the complaint before: public sector employees enjoy job security, large benefits and on top of that they are better paid than private sector employees. And this is particularly upsetting right now where the latter are asked to accept pay cuts and face the prospect of higher tax rates. Now does the complaint hold water?

Jeffrey Thompson and John Schmitt show that is does not. While it is true that public sector employees enjoy higher pay, looking at such big average is misleading. Indeed, civil servants are on average also better educated and older. If you take this into account and determine the wage premium for different levels of education across public and private sector workers in New England, Thompson and Schmitt find that civil servants are in fact paid 5% less than comparable other workers at the bottom of the wage distribution, 3% less in the middle and 13% less for high wage workers. If you just concentrate on education, those with at least an undergraduate degree face a 7% penalty in the public sector, while those who have just a high school degree get a 1.6% premium. In other words, there is a substantial compression of wages in the public sector compared to the private sector, and averages are lower, at least in part reflecting the job security premium.

Wednesday, October 27, 2010

Greed has been put forward a one the main reasons for the current crisis, yet there is plenty of evidence for altruistic behavior around us. In fact, plenty of experiments have shown that people are willing to share with complete strangers, because of some sense of fairness. There is also evidence, reported here recently, that altruism can differ quite a bit across populations. This raises the question of why altruism differs across people.

Kirsten Häger performs some experiments on seven to ten year olds in Germany and comes to an interesting conclusion: altruism is more prevalent among the older children, which would lead us to think that altruism is acquired. From casual observation on playgrounds, it is certainly so that toddlers are very egoistic and need to be reminded to share with others. Over the years, this idea seem to stick with them.

But if education is important for altruism, the there should be some explanatory power in socio-economic indicators, yet there seem to be none according to Häger. It then altruism not acquired after all, but rather something hard-coded that reveals itself as one grows up? Or is it something that one acquires not from one's direct environment (family and school), but from a larger environment? That would explain differences across societies.

Tuesday, October 26, 2010

On a regular basis, my employer offers workshops and sign-up drive for long-term care insurance. I have never bothered with it, and I do not think any of my colleagues has. Yet, it makes perfect sense to participate: the likelihood that one needs long-term care, either with a visiting nurse or in a nursing home, is high and expensive. Yet, this is an eventuality that is so far away that it is discounted heavily from our minds.

Pierre Pestieau and Grégory Ponthière say the problem goes beyond this discounting. It is a multiple equilibrium situation. Currently, very few people buy this type of insurance, which makes it more expensive, hence few people buy it. If there were a larger market, it could be sustained by lower costs.

Monday, October 25, 2010

The equity premium puzzle is probably one of the most controversial puzzle in economics. For one, it is rather difficult to measure properly the equity premium, second the puzzle is about a risk aversion parameter that is itself difficult to measure, and third the literature is pretty much all over the place.

Casper van Ewijk, Henri L.F. de Groot and Coos Santing perform a meta-analysis on the topic: they gathered all the papers about the equity premium they could, could the premises and the results and tried to make some sense from all this. They conclude that the equity premium tends to disappear with time and development, and with lower GDP volatility. Thus is should be normal that the equity premium kind of vanished during the Great Moderation. Now get a theory to replicate this. Assume that financial markets develop as time goes, and you can easily obtain a reduction in the equity premium in any sensible model. No need for strange preferences, complex arguments about taxes, or large improbable events.

That said, the equity premium puzzle is about the size of the premium, not how it changes. But given the fact that it seems to be shrinking, the puzzle may soon be moot.

Sunday, October 24, 2010

The empirical evidence on the economic impact of democracy is really mixed. While the literature tends to show that democratization is good for the poorest economies, the opposite is true for rich ones. My hunch is that the poorest economies are in such a state because of massive mismanagement, in particular corruption, and a democracy can avoid the brunt of this.

But for a rich country, why insist on democracy? Look for example at the Southern European countries, where reforms are very obviously necessary, their pension systems come first to mind. Yet, governments have a very very hard time wringing these reforms through and may even fail to do so. The public is easily manipulated and governments have to give in for their own sake.

Look also at the United States. Elections there are now determined by who can hammer the most frequently his version of the facts on televisions ads, with the media failing to fact check anything because it needs all this ad revenue. This is populism to the extreme, nobody bothers to explain trade-offs and politicians on both side advocate impossible policies. The realist has no chance.

What is the solution? A benevolent dictator would be ideal, but how to make sure the dictator is and stays benevolent? Or maybe the problem is really with representative democracy, that is politicians depend on popularity contests for their livelihood and those contests are easily rigged. A solution then could be direct democracy, which gives much more responsibility to the electorate, who may they seek to get more educated about issues before voting. But this could also go horribly wrong if it fails to do so.

I am really torn. But I am sure about one thing: democracy is certainly not the panacea civics textbooks seem to teach.

Friday, October 22, 2010

Risk sharing contracts are good contracts, and they can have an important welfare benefit. However, it is not quite clear that these contracts should be valid for a life-time. Indeed, this is what marriage is. Aside from the fact that these contracts are restricted to be signed between people of opposite gender, one can also question why not more people could be included in them. That would be good risk diversification. The problem is that a marriage contract is not just about risk sharing (and for that we have a market for insurance contracts nowadays), it is also about limiting sex choices and commitments to supporting children. But all this could be achieved without marriage.

Anyway, Stefania Marcassa and Grégory Ponthière ask whether marriage contracts should be eternal and find that in most cases they should not. Their argument has nothing to do with risk and uncertainty, rather with declining match quality and unequal bargaining power. Indeed, when one potential partner has little bargaining power, marriage gives an important veto power. But when bargaining powers are rather equal, like they are nowadays, long-term contracts become more interesting because no one has an incentive to veto a marriage due to unequal power.

Thursday, October 21, 2010

On average (but not now), unemployment rates in most European countries are higher than in the United States. This has been blamed on more generous unemployment insurance, high firing costs, lack of mobility, high taxes, union power, too specific education, and measurement. One possibly neglected aspect, at least as far as I know is the impact of minimum wages. Few people actually work at or close to the minimum wages, but these tend to be entrants on the labor market, and what happens to the young tends to persist for many years after the look for work.

Aspen Gorry uses a suddenly popular labor search model that differentiates between those seeking a first job (the young) and those that have experience (the old). Varying the level of the minimum wages from American to French levels, he finds that about 50% of the gap between youth unemployment rates can be explained. What this is implies is that the minimum wage prevents some of the young workers to find their first job. And this lack of experience implies that they enjoy only later the job stability of an incumbent. Thus the impact of the minimum wage adds up quickly for the aggregate unemployment rate.

Two additional comments. First, this model does not explain European countries that have high unemployment yet no minimum wage, such as Germany. Second, while the minimum wage is binding for very few jobs in the US in normal times, it may be more binding now, thus giving another reason for the strong surge in unemployment (and presumably its rapid shrinking once things get back to normal).

Wednesday, October 20, 2010

The official story is that copyright encourages creators by giving them temporary monopoly rights. The unofficial story is that copyright prevents the diffusion of art and knowledge, and nowhere is it as frustrating as with academic publishing. Commercial publishers sell the research others paid for, and can extract substantial rents because researchers have to publish in established outlets for reputation, tenure and promotion.

Giovanni Ramello remarks that there is another unfortunate consequence of copyright in academic publishing: having been granted some market power, the monopolist will seek to extend this market power through acquisitions and thereby obtain even more dominance. The obvious example is Elsevier, which has reached now a market share that should trigger anti-trust investigations along with profit margin in the order of 30%. The situation is quite bad in Economics, as scholarly societies have done little to prevent Elsevier taking hold of the major field journals, thereby making it essential to any tenure file. And given this, research libraries have no choice but subscribe to those journals, falling in the trap of the monopolist.

In other sciences, I hear the situation is not much better. And I have reported previously about horror stories that still seem to have little impact (1, 2).

Tuesday, October 19, 2010

Britain and Ireland currently go through much soul searching on how to reform the financing of higher education. As for health care, education is becoming more expensive as it is a service, which we do not know yet to scale well, while manufacturing has benefited from tremendous improvements in mass-production and can be relocated to where it is the most efficient. If higher education is becoming more expensive, who should pay for it? Obviously, there is a large private benefit to getting an university degree. Thus the student should also pay a large share. There is a social benefit as well, as a well educated workforce brings all sorts of positive externalities, which means that society should subsidize higher education as well. But not too much, as these subsidies are regressive: while rich people pay more taxes, they benefits even more from higher education subsidies, as their children are more likely to attend university and stay there longer. But if university tuition is so expensive, what to do with those students who are credit constrained? Should they get subsidies, loans, or just deal with it?

Neil Shephard suggests a complete overhaul of the system. Here are its components:

Students are charged the full cost of their education by universities.

They get an explicit scholarship from the government for part of this tuition. This makes is visible that the state is helping.

Students have the option of deferring the payments to the universities. As the universities are taking the risk when a student could default or make little money, they will make sure students will get a good education (and not admit students who should not go to college).

This means that universities will make loans to their students. These loans should also cover living expenses.

I think this is a very good programme. It essentially boils down to students borrowing against future income, and seeing how the return to education is vastly superior to the financial cost, they should want to take this opportunity as long as there is a market. Universities are the ones providing this market and they are incentivized to provide a good educational product.

The suggestion is in fact very similar to the credit products that MyRichUncle offered before the financial crisis in the United States: it gave loans to students against a share of future income for a set time. The loan amount was determined by student performance and major, thus taking into account the expected value of a university degree. With the Shephard proposal, it is up to the university to provide this value.

Monday, October 18, 2010

A large, but shrinking, proportion of models in macroeconomics assume the existence of a representative agent. While there is clear evidence that households are heterogeneous, under some conditions aggregation may still hold. But even if it does not, what matters is whether it makes a quantitative difference.

Christos Koulovatianos, Carsten Schröder and Ulrich Schmidt address the question from a different angle. They ask whether differences in household size matter. They show it does not, theoretically, if the utility functions exhibit household-size economies (beyond subsistence consumption) that are invariant with income. I think that what the authors want to say here is that household size does not matter as long as preferences are such that consumption demand is linear in household size, which in fact does not imply that preferences are heterogeneous. Household size is just an argument in the household utility function. Or: household utility can be aggregated for individual utilities if the decisions rules can be aggregated, which is the case when they are linear.

Anyway, beyond these semantic issues, Koulovatianos, Schröder and Schmidt then provide survey evidence documenting that preferences have indeed the required property, namely that households perceived that the income necessary to maintain a given standard of living is linear in the number of its members. What is interesting here is that the survey covers many countries, possibly preempting the criticism I mentioned the other day.

On a separate note, this paper is particularly painful to read. It runs for 89 pages, and it is very confusing (even more than my post) because the authors do not use the right terminology. Also, they need to learn the virtues of conciseness and precision. I hope they did not send it to a journal in such bad shape. And of course they assume that all households have the same time preference, against which there is ample evidence and which matters much more as it has strong implications for savings.

Friday, October 15, 2010

Females are now more numerous than males in most levels of education, and they perform better in school. Why is that? One hypothesis is that there are biological differences that make that men are better at tasks that require force, while women are better when reasoning is asked for. This is the brawn versus brain hypothesis, and as todays economies indeed ask for more intelligence than brute force from their workers, women find more opportunities and better pay.

Mark Pitt, Mark Rosenzweig and Nazmul Hassan build a model of investment in human capital that differentiates genders. Better nutrition improves strength and education improves skills. Individuals make these choices, as well as in which activities to work. Using panel data from rural Bangladesh, they find that model is a reasonable description of reality. That is particularly interesting, because rural Bangladesh does not strike me as an economy where brain would dominate brawn. Also of interest is that improvements in health do not increase education for men, it may even reduce it, while women education clearly benefits from them. Thus policies that focus on health improvements are likely to improve women's schooling more than men's, lead to more occupational differentiation across genders, and a larger gender wag gap.

Thursday, October 14, 2010

Compared to two centuries ago, today's world is much different, as the standard of living has dramatically increased, along with population. This has been in strong contrast with previous history, characterized by growth close to zero in both population and the standard of living. During this period, there has been a very strong demographic change, called Demographic Transition, with a large decrease in mortality followed by a decrease in fertility. This has implied that every country that went (or still goes) through this transition has a period of high population growth while mortality is low and fertility has not yet declined. Such major shift in demographics have large implications, but it is also important to understand what triggered the Demographic Transition, especially as some countries are now just at the start of it.

Oded Galor tries to disentangle to various triggers that have been proposed. As this is a dynamic process, obviously some triggers are going to be more important at different stages of the transition. There is too discussion in the paper about the various theories and the quantitative evidence for and against them for me to summarize it efficiently here. Galor concludes that the following theories hold water when plunged into the data: First there is the theory that the higher demand for human capital during industrialization lead to a decline in fertility as parents concentrated more on the quality of their children rather than their quantity. Second, as the wage gap between females and males decreased, the increase in female labor force participation and the associated higher opportunity cost of having children for mothers reinforced the decrease in fertility.

What is important here are the theories that did not passed the test of the data according to Galor: the theory that the emergence of financial markets made in less necessary for parents to have been adult children to support them in old age; the theory that a decline in mortality lead to a too high number of surviving children; and the theory that the general increase in income lead to a rising opportunity cost of raising children.

Wednesday, October 13, 2010

Why do people simultaneously hold substantial cash and high interest credit card debt? I previously reported that this could be explained by the demand for liquidity as some goods cannot be purchased on credit. While that explanation seemed to be a good one quantitatively, it does not mean that thtere is no room for other ones as well.

Scott Fulford offers another one: liquidity is necessary for unexpected changes in borrowing limits. Basically, people keep cash or savings so that they have something to live from in case their credit line gets unexpectedly reduced. That seems to be a very poor strategy, though. Given the high interest rate on credit cards, why not lower the credit balance with those savings? You pay less interest, and you end up with exactly the same balance when you are the most constraint. If fact you are even better off in the latter situation, because past interest payments are lower and the balance is thus lower. The reason why household in this model still hold cash is that there is a very peculiar way in which the debt limit is stochastic: it is either zero or some fixed number. Thus it is not some reduction in credit lines, it is a complete cancellation out of the blue. That is important for household choices. In fact, this may give some ideas to credit card companies, because this implies that households will want to have high interest credit card debt while having low interest savings. Crazy.

Tuesday, October 12, 2010

There is a long standing and quite robust result in the literature, originating with Christophe Chamley and Ken Judd, that physical capital should not be taxed. Larry Jones, Rodolfo Manuelli and Peter Rossi extend this reasoning to human capital. These are very strong results that are not borne by the data, thus either the models are missing something, or economists still have a lot of convincing to do.

Christoph Braun challenges the last result on a technicality. Jones, Manuelli and Rossi assumed that human capital exhibits constant returns to scale in its production function, that is, a doubling of current human capital doubles ceteribus paribus future human capital. Braun take the opposite extreme: current human capital has no impact on future human capital, as the latter is only dependent on the time dedicated to education. The first assumption was very convenient, because it made human capital disappear from key equations, but this also drives the no-tax result. The latter makes it simpler than an intermediate assumption (decreasing returns to scale), but give a very different result from the original paper: in particular, the return to human capital does not vanish from the taxation equation and thus should be taxed. However, the accumulation of human capital is encouraged through the tax deductibility of tuition. And in the end, physical capital is still not taxed.

Sunday, October 10, 2010

Today is October 10, 2010, which is the binary equivalent of 42. I was looking forward to this day, as 42 is the "Ultimate Answer to the Ultimate Question of Life, The Universe, and Everything." Alas, my day was not fruitful in this respect, maybe we have to wait for another century for The Ultimate Answer. And then, the context could be very different, as human life may have few similarities with today's. Just think how life today compares to that of 1910, and how we now ridicule some aspects of everyday life then. If you still follow my train of thought here, what would people a century from now find ridiculous about our lives nowadays? Here are a few candidates, and only the far future will tell whether I am right.

We drive cars ourselves. How inefficient and, especially, dangerous.

We can pollute mostly for free.

Water is essential, yet cheap.

Nationalism.

The amount of garbage we generate, in particular paper and plastic.

Major projects are funded and conducted at the national level: space exploration, fundamental research.

Smoking tobacco.

Transportation centered on individual fuel engines.

How religious people are.

Circumcision.

We tolerate a huge dispersion in standards of living across the Earth.

Life-time insurance contracts between people of the same gender are illegal is many places.

Private and exclusive health care provision.

Immigration laws.

Patents and copyright.

Intelligent design.

We kill sociopaths.

We pay to put drug users in jail instead of taxing them.

We need new flu immunization every year.

TV and celebrity oriented leisure.

That abortion needs to be an option.

The catholic church can get away with child molestation on a grand scale.

We use toilet paper and flush with water.

We devote lots of resources to lawns.

We prefer pumping expensive carbon into the atmosphere rather than using free solar energy.

We expect physicians to know everything on the spot without looking it up.

The USA is a country, while Europe is not one.

Government officials are poorly paid and are expected to outdo themselves for the common good.

Tuesday, October 5, 2010

The saving behavior of people is heterogeneous, and what drives it is important for policy. In particular, there is a strong belief that people do not save enough, either because they know the state will bail them out in old age or because their intertemporal preferences are not aligned with the social planner. In any case, what drives people to particular saving behaviors?

Henrik Cronqvist and Stephan Siegel use data from identical twins in Sweden and conclude a little bit over everything is contributing. Of course, results will depend on whether people have faced circumstances that make saving difficult. 35% of the differences in saving propensity can be explained by genes, more so for men, educated and wealthier people. Parental influence is stronger when other siblings are present, which the authors interpret as a situation with less competition for parental resources (why? they are also competing for the parents' attention). But all this means there is still 65% of the variation that can be educated. Which is a lot.

Monday, October 4, 2010

Economic thought, especially in macroeconomics, goes through episodic changes. These changes are very slow to occur, and historians of economic thought try to analyze what brought these changes and how they happened. The recent doctrinal changes in Eastern Europe offer in this respect a particularly interesting exercise, because everything happened very fast. In particular, you did not even have to wait for an old generation to retire or die for fundamental changes to happen.

Nikolay Nenovsky studies, from personal experience, what happened in Bulgaria. The evolution there was particularly dramatic there because the Russian Perestroyka was largely ignored by the political and intellectual class, and thus change had to happen much faster thereafter. Also, the economic transition happened in a theoretical vacuum, as only transition to communism was researched. Subsequently, economic research was largely event driven, reacting to price liberalization, restructuring of state ownership, foreign debt issues and the currency board.

Previous to reforms, economists were in two camps: those who studied socialism, and those who were to point out the ills of capitalism. The latter were much more ready to understand the transition and emerged as intellectual leaders. The first found refuge in Keynesianism and institutional economics. Bur all lacked empirical skills, and, ironically, sociologists took this over. But the big agents of change were the World Bank and the IMF, through their missions and advice, and imported western textbooks. Nowadays, western thinking has been adopted without much discussions about its fundamentals. Microeconomics is largely neo-classical, and macroeconomics mostly Keynesian. The latter is not surprising, given where Bulgaria is coming from.

Friday, October 1, 2010

The Big Mac index, created in 1986 by the Economist to estimate the over- or under-evaluation of currencies, is based on the price comparison of a uniform good across countries. In the best case, purchasing power parity would hold, and it typically does not. But the choice of McDonald's Big Mac always struck me as poor for such an exercise. Its major ingredient, meat, is subject to regulation and subsidies that vary considerably across countries, including trade barriers. And a major part of its price is the "service" which is offered by the restaurant, which is non-tradable. In short, it would even be a surprise were purchasing power parity to hold.

Kenneth Clements, Yihui Lan and Shi Pei Seah have looked at this more formally than I just did. They find that the Big Mac index indeed suffers from biases, and thus its predictions are biased. But they can be corrected. The index even beats the best predictor of exchange rates, at least at medium to long range, the random walk. This should not surprise us, however. After all, if there are strong deviations from purchasing power parity, they should correct themselves in the long run.

I prefer the iPod index that the Commonwealth Bank of Australia computes periodically. iPods are traded, identical (once you choose which one to index), and widely available. Only drawback: Apple has the ability to price to market thanks to its market power. I am waiting for someone to use it to see whether it beat the Big Mac index.